Nonqualified Deferred Compensation Plans for Small Business

1. Nonqualified Deferred Compensation Plans Cutting Edge Ideas for Small Business <Presenter:> <Title: > <Date: > LFD 0706-1572 6/07

2. This seminar is for continuing education use only. It is not for use with the general public. It is intended to be accurate and authoritative in regard to the subject matter covered. It is presented with the understanding that I am not engaged in rendering legal or tax advice. Lincoln Financial Group provides the sales concepts discussed for information purposes only. While this seminar discusses general tax aspects and concepts of planning with insurance, we make no representations as to suitability for individual clients. Interested parties should be strongly encouraged to seek separate tax and legal advice before implementing a plan of the type described in this presentation. For continuing education purposes only. Not for use with the public. LFD0706-1572

3. IRS Circular 230 Disclosure Any discussion pertaining to taxes in this communication (including attachments) may be part of a promotion or marketing effort. As provided for in government regulations, advice (if any) related to federal taxes that is contained in this communication (including attachments) is not intended or written to be used, and cannot be used, for the purpose of avoiding penalties under the Internal Revenue Code. Individuals should seek advice based on their own particular circumstances from an independent tax advisor. For continuing education purposes only. Not for use with the public. LFD0706-1572

4. Nonqualified Deferred Compensation • What is a nonqualified deferred compensation plan? • Basic types of nonqualified deferred compensation plans • Deferral plans • Supplemental plans • Death benefit only plans For continuing education purposes only. Not for use with the public. LFD0706-1572

5. Advantages of Deferred Compensation • It’s a extra benefit that an employer can provide for key employees without having to include others. • It can be used to attract and reward key employees by providing extra benefits over and above qualified plans. • It can be used to retain key employees with “golden handcuff” provisions. For continuing education purposes only. Not for use with the public. LFD0706-1572

6. Advantages (continued) • Few ERISA requirements • It is not subject to the usual tax or ERISA non discrimination rules. • There may be different plans for different employees; selectivity and individuality are hallmarks. • The employer may be able to recover all its costs. For continuing education purposes only. Not for use with the public. LFD0706-1572

7. Disadvantages • Funds in plan are subject to corporate creditors • Benefits are not deductible until paid • Premiums paid to informally fund the plan are not deductible to the business For continuing education purposes only. Not for use with the public. LFD0706-1572

8. 409A Rules • Deferred compensation after the American Jobs Creation Act 2004 • The Act added Section 409A to Internal Revenue Code (IRC) and new rules are effective for deferred compensation amounts on or after 1-1-08 • Definition of nonqualified deferred compensation (NQDC) For continuing education purposes only. Not for use with the public. LFD0706-1572

9. Who Is Affected By 409A • Any person participating in a deferred compensation plan • Key employees (“top heavy employees”) in publicly held companies are further impacted For continuing education purposes only. Not for use with the public. LFD0706-1572

10. Key Provisions of IRC 409A • Election to defer income • Acceleration of benefits • Distributions of deferred compensation For continuing education purposes only. Not for use with the public. LFD0706-1572

11. Key Provisions of IRC 409A (continued) • Hardship or emergency distributions • Triggers of payment in the event of termination of plan, change in financial health or condition of employer, and “haircut” plans are no longer allowed • Rabbi trusts For continuing education purposes only. Not for use with the public. LFD0706-1572

12. Key Provisions of Final 409A Regs. • Follow proposed regs in most material respects • Voluntary separation for “good reason treated as involuntary separation • Rules relating to reimbursement arrangements • Plan documentation requirements explained For continuing education purposes only. Not for use with the public. LFD0706-1572

13. Key Provisions of Final 409A Regs. (continued) • Tandem elections with qualified plans less effective • “Specified employee” more clearly defined • Several provisions on stock options and SARs • Aggregation rules liberalized For continuing education purposes only. Not for use with the public. LFD0706-1572

14. Penalty for Non-Compliance • All current and prior years deferred compensation becomes immediately taxable if 409A provisions violated • Additional tax of 20% on the amount required to be included in income • Interest penalty will be assessed at the IRS’s underpayment rate plus 1% For continuing education purposes only. Not for use with the public. LFD0706-1572

15. Planning Opportunities under 409A • Review all plan types to determine if they are impacted by new 409A legislation • Do not modify any NQDC without evaluating the pros and cons of any changes • Consider freezing the old plan to preserve “grandfathering” status of existing plan • Examine record keeping capabilities to segregate old money from new money • Create new NQDC plan for future deferral with changes to legal documents and administrative procedures For continuing education purposes only. Not for use with the public. LFD0706-1572

16. Qualified Plan Limits • Allowances for 2007 • 401(k) deferral limit: $15,500 ($20,500 if age 50 or older) • Annual addition limit for contributions to Defined Contribution plans: $45,000 or 100% of pay • Maximum accrued limit for Defined Benefit plans: $180,000 • Annual compensation limit: $225,000 • Limits cause “reverse discrimination” for highly compensated For continuing education purposes only. Not for use with the public. LFD0706-1572

17. Qualified Plan Discrimination For continuing education purposes only. Not for use with the public. LFD0706-1572

18. ERISA • Unfunded plans provided by an employer for “a select group of management or highly compensated employees” or “excess benefit plans” that are solely for the purpose of providing benefits for certain employees in excess of the limitations under IRC 415, are exempt from ERISA participation, vesting, and funding requirements and have streamlined reporting requirements. For continuing education purposes only. Not for use with the public. LFD0706-1572

19. Unfunded Plans • The employer promises to pay benefits. • It may set aside assets to use for that. • But, those assets belong to the employer. • The employer’s creditors can get to them. • The employee does not have any interest in, or rights to, any funds or trust. For continuing education purposes only. Not for use with the public. LFD0706-1572

20. Basic Tax Facts • Employer contributions to a plan are not tax deductible when made nor taxable to the employee at that time. • The employer gets a tax deduction when benefits are actually paid to the employee (or beneficiary) and those amounts are then taxable to the employee (or beneficiary). For continuing education purposes only. Not for use with the public. LFD0706-1572

21. Corporate Tax Brackets Taxable Income Tax Rate on Excess 0 0 15% $ 50,000 $ 7,500 25% $ 75,000 $ 13,750 34% $ 100,000 $ 22,500 39% $ 335,000 $ 113,900 34% $ 10,000,000 $ 3,400,000 35% $ 15,000,000 $ 5,150,000 38% $ 18,333,333 $ 6,416,667 35% For continuing education purposes only. Not for use with the public. LFD0706-1572

22. 2007 Joint Return Tax Rates Tax Taxable Income Rate on Excess $ -0- $ -0- 10% 15,650 1,565 15% 63,700 8,772 25% 128,500 24,972 28% 195,850 43,830 33% 349,700 94,601 35% For continuing education purposes only. Not for use with the public. LFD0706-1572

23. FICA Taxes • The deferred compensation is subject to Social Security taxes the later of when it is earned or when it is vested. • The hospital insurance tax (1.45%) applies to all comp when earned. • Retirement/survivorship benefits are not subject to FICA taxes and do not reduce Social Security benefits. For continuing education purposes only. Not for use with the public. LFD0706-1572

24. Effect of Taxes (assuming 40% tax brackets) • If an employer pays an employee $10,000 in deductible compensation, it costs the employer $6,000 after taxes. • If the employer sets aside the $10,000 in a deferred compensation plan and cannot deduct it, it costs the employer $10,000. • Therefore, the employer can only set aside $6,000 in a deferred compensation plan for the same cost as $10,000 of deductible comp. For continuing education purposes only. Not for use with the public. LFD0706-1572

25. Employer’s After Tax Costs • $10,000 employee deferral • 40% employer income tax rate • Employer’s tax on deferral • $10,000 x .40 = $4,000 income tax • Employer’s after tax cost • $6,000 after taxes ($10,000 - $4,000) For continuing education purposes only. Not for use with the public. LFD0706-1572

26. Fund Accumulation • $10,000 per year for 20 years - • @ 10% gross = $630,000. • @ 6% net = 390,000. • $6,000 per year for 20 years - • @ 6% net = 234,000. • @ 10% gross = $378,000. For continuing education purposes only. Not for use with the public. LFD0706-1572

27. Equal Results • If the employee gets $10,000 of current comp, he/she nets $6,000, and has $234,000 after taxes in 20 years. • If the employer sets aside $6,000 per year for 20 years @ 6% net, it has $234,000. • The employer can then pay out $390,000 for an after tax cost of $234,000, and the employee nets $234,000 after taxes. For continuing education purposes only. Not for use with the public. LFD0706-1572

28. Still Equal Results • If the employer sets aside $10,000 in a deferred compensation plan it will have $390,000 @ 6% net, can then pay out $650,000 to the employee, for a net cost of $390,000 and the employee will net $390,000 after taxes. • Or, the employer could pay the employee $16,666 per year, which costs it $10,000 and nets the employee $10,000, and the employee would have $390,000 net in 20 years. For continuing education purposes only. Not for use with the public. LFD0706-1572

29. Moral • If the employer and employee tax rates are equal then there is no tax or cost advantage in deferred compensation. • The deferred comp advantage to the employer is “golden handcuffs”. • The risk to the employee even if fully vested is to the employer’s creditors. For continuing education purposes only. Not for use with the public. LFD0706-1572

30. Voluntary Deferrals • There is no advantage for an employee to make voluntary deferrals unless the employer • Credits the full amount to the deferred comp account and • Credits a reasonable rate of interest on the funds deferred For continuing education purposes only. Not for use with the public. LFD0706-1572

31. Type of Employers • Large or small companies may use them. • Generally, not applicable for Sub “S” corporation owners, partners or LLC members, because they are taxed on all the business earnings. • Not applicable for sole owners of “C” corps since the business dies/retires with them. For continuing education purposes only. Not for use with the public. LFD0706-1572

32. Types of Plans • Defined Contribution - the benefits are based on the value of the deferred funds (like a 401(k) or profit sharing plan). • Defined Benefit - a specified amount of benefits is promised (like a pension plan). • Contributory or Non Contributory (most plans are non contributory). For continuing education purposes only. Not for use with the public. LFD0706-1572

33. Basic Funding Facts • The employer does not have to set aside any funds to pay the benefits. • Any funds the employer does set aside remain at the risk of the employer’s creditors; the employee does not have any direct interest. • “Rabbi” trusts may be used to hold the funds, but they are subject to the employer’s creditors (the employee does not come first). For continuing education purposes only. Not for use with the public. LFD0706-1572

34. Why Use Life Insurance • The tax free death benefit to the employer can fund a survivorship income and/or provide cost recovery. • The cash values accumulate on a tax deferred basis for the employer. • The employer can make untaxed loans or withdrawals to pay benefits. For continuing education purposes only. Not for use with the public. LFD0706-1572

35. Other Funding Options • Fixed or variable annuities? • Accumulation is taxable. • Mutual funds, stocks, bonds? • Interest and dividends are taxable. • Short term gains are taxable. • Long term capital gains are taxable. • 15% rate not applicable to corporations. For continuing education purposes only. Not for use with the public. LFD0706-1572

36. Funding Example • A company in a 40% tax bracket promises to pay an executive $100,000 a year for 10 years at retirement (65) or to his spouse if he dies before then. • The company’s gross liability is $1,000,000, but only $600,000 after taxes. • Therefore, if it has $600,000 of insurance on the employee, it has its costs covered. For continuing education purposes only. Not for use with the public. LFD0706-1572

37. Funding Example (continued) • If the employee dies before age 65, the company collects $600,000 tax free and can pay out $1,000,000 tax deductible. • If the employee lives to 65, the company keeps the policy in force, pays out the $100,000 per year from earnings, and ultimately collects $600,000 when the employee dies. • So the company recovers its after tax benefit costs; but it has a cost equal to the premiums. For continuing education purposes only. Not for use with the public. LFD0706-1572

38. Funding Example (continued) • Assume the premiums for the $600,000 policy are $6,000 per year to age 65. Thus, the company’s cost is $120,000 (20 years). • So, the company’s gain is $480,000 ($600,000 - $120,000). • So, it has a net cost of $120,000; the premiums. • How much insurance must it buy in order to cover the premiums and benefit costs? For continuing education purposes only. Not for use with the public. LFD0706-1572

39. Premium and cost recovery • In order to cover the after tax costs of the benefits ($600,000) and the premiums for the policy, it takes $750,000 of insurance with $7,500 annual premiums. • Insurance death benefit: $750,000 • Minus total premiums: - 150,000 • Equals cost recovery: = 600,000 For continuing education purposes only. Not for use with the public. LFD0706-1572

40. Full Funding • The previous was a “cost recovery” example - the company recovers its after tax benefit costs and premiums from the death benefit. • Full funding is another option - where the company takes money from the cash values (untaxed from withdrawals and loans) to cover the after tax cost of the retirement benefits. • Thus, it takes $60,000 annual withdrawals/loans to pay $100,000 deductible benefits. For continuing education purposes only. Not for use with the public. LFD0706-1572

41. Insurance funding • Thus, there are three ways to use life insurance to “fund” a plan: • death benefit recovery of benefit costs only. • recovery of premiums and benefit costs. • cash value funding of retirement benefits • Which to use mainly depends on the ability of the company to pay the premiums. For continuing education purposes only. Not for use with the public. LFD0706-1572

42. Accounting • APB-12 requires that the after taxpresent value of an employee’s future benefit be expensed each year on a systematic basis. • FASB 106 amends APB-12 to require accrual of benefits over the required service period • Employee @ 45. • Benefit = $100,000 for 20 years at age 65. • After tax cost of benefit = $60,000 per year. • Present value @ 6% = $688,000. • Annual expense = $17,640. For continuing education purposes only. Not for use with the public. LFD0706-1572

43. Accounting • With a defined contribution plan the annual expense (charge to earnings) is the amount credited to the employee’s account. • Example: $10,000 deferral. • Expense = $10,000, plus • Interest @ 6% = $600. For continuing education purposes only. Not for use with the public. LFD0706-1572

44. Accounting for Life Insurance • FASB 85-4: the difference between the annual premium and increase in cash surrender value is an expense (charge to earnings). • $10,000 premium, $4,000 CSVDebit Credit Ins. Expense 6,000 Insurance CSV 4,000 Cash 10,000 For continuing education purposes only. Not for use with the public. LFD0706-1572

45. Prospects • Generally for larger, multi stockholder, C corporations; not a sole stockholder. • Not applicable to S corp. stockholders, partners or LLC owners. • If NA, use bonus or split dollar plans. • But, can be used for any non owner key employees of C/S/P/LLCs. For continuing education purposes only. Not for use with the public. LFD0706-1572

46. Next Steps • Get a list of names. • Call them. • Go see them. • Make a proposal. • Get another list of names. For continuing education purposes only. Not for use with the public. LFD0706-1572

47. Thank you Questions? For continuing education purposes only. Not for use with the public. LFD0706-1572

48. Securities and investment advisory services distributed byLincoln Financial Distributors, Inc., a broker/dealer and registered investment advisor. Principal office is located at 2001 Market Street, Philadelphia, PA 19103-7055, phone 877 533-0003. Insurance products are offered through Lincoln affiliates. Lincoln Financial Group is the marketing name for Lincoln National Corporationand its affiliates. For continuing education purposes only. Not for use with the public. LFD0706-1572